Net income is the money left over after a company’s expenses have been paid.
Examples of net income
The most basic net income formula is:
Total Income - Total Expenses.
Total income refers to both operating and non-operating income. For example, in addition to sales revenue, a company may receive income from investments. Also, if a company divests assets, the proceeds will be counted as income.
Net income versus gross revenue
Net income and gross revenue are, respectively, the last and first lines on a company’s profit and loss account. Individually, both are useful indicators of a company’s overall financial health.
For investors, however, it can be even more useful to trace the path from a company’s gross revenue to its net income. This lets them judge how well a company is managing its expenses.
It can, therefore, provide insight into both the quality of a company’s management and the company’s future prospects. For example, if a company has high revenues and a high operating income but a low net income, it is an indicator that it is spending a lot of its budget on non-operating expenses.
If the money is spent on marketing, it may be a sign that the company is pushing for growth. If, however, it’s going on administration, it may be a sign the company has inefficient back-office processes.
Net income versus profit margin
Net income is used to calculate a company’s profit margin. A profit margin is the amount of profit the company makes on each item it sells or each service hour it charges for.
The formula for calculating profit margin is: Net Income/Total Revenue
A company’s profit margin is also a good indicator of how well it’s controlling its expenses. That said, profit margins can vary widely from one business sector to another. It’s therefore vital that investors compare a company with its peers, not with companies in a totally different business sector.
As a rule of thumb, business sectors that work on volume tend to have lower profit margins. The volume of sales, however, should compensate for this to give a healthy net income. By contrast, the businesses with the highest profit margins often have the lowest volume of sales.
Net income versus earnings per share (EPS)
Net income is also used to calculate earnings per share. The formula for calculating earnings per share is:
Net Income / Total Shares Issued
Earnings per share is completely different from both share price and shareholder dividends although it will often influence both.
The share price is simply the price that a share trades for on the stock market. Shares with higher EPS values are likely to trade for higher prices than shares with lower EPS values although that is not absolute.
The shareholder dividend is the money taken out of the company and distributed to its shareholders. Companies with higher net incomes are typically in a better position to pay shareholder dividends than companies with lower net incomes.
Again, however, the fact that a company can afford to pay a shareholder dividend does not mean that it will. For example, younger companies may prefer to hold onto their profits to finance growth. Even more established companies may prefer to hold profits as assets on their balance sheet in case they have to deal with unexpected expenses.